CONFERENCE CALL: East Capital sees a turning point for Russia

By bne IntelliNews September 13, 2010

Nicholas Watson in Prague -

One issue that was exercising the minds of those at the East Capital Summit in Prague on September 8-10 centred on why Eastern European markets, especially Russia's, are so cheap compared with the other Bric markets Brazil, India and China.

To some old Russia hands, this a question that's lost its usefulness over the years. "Why does everyone say the same thing over and over about Russia?" sighed one. "Why not accept that the spreads between 'BIC' and 'R' are the spreads and that's the way it may always be?"

Such defeatism is understanding, given the persistence of this phenomenon. The problem, argue some, is that the Bric markets are, apart from being large emerging markets that are becoming more central to world economic growth and part of a snappy marketing acronym, simply too dissimilar to make any meaningful comparison and the persistence of the spread between Russia and the rest is because of a Russian inverse version of "American exceptionalism."

Peter Elam Hakansson, chairman and head of portfolio management at East Capital, admits that Russia being what it is - an extremely complex country/society with a lot of historical baggage - means there could always be some kind of investor discount applied to it. However, he stresses it's not so much the existence of the discount that's troubling, but the size. "Valuations today in Russia are the same as 10 years ago and many Eastern European markets have not really recovered from the crisis," said Elam Hakansson. "You do have to factor in the risk and volatility factor, but we think it's exaggerated right now."

The figures are certainly startling. 10 years ago, Russia was just emerging from a financial crisis, a debt default and devaluation of the ruble, but is today sitting on the world's third largest foreign currency reserves, the state and indeed the average Russian is debt free, and the country's output of natural resources that the emerging world so desperately needs to fuel their economies is near an all-time high. Even so, the Russian market is trading on a price/earnings (PE) ratio of 7x, little changed from the 6x it was trading at 10 years ago. Compare that with the other Bric nations: the Brazil market, for example, is trading on a PE of 14x, yet its economy is just as dependent on commodities and its population is a lot less well educated and wealthy than in Russia; China is at about 15x; and India is above 17x.

The size of the discount, Elam Hakansson and his colleagues at East Capital argue, is unsustainable given the concrete progress that Russia has made over the past decade and we are nearing an inflection point where the Russian market will undergo a re-rating, which should be a bonanza for investors.

Anecdotal evidence suggesting a turning point is near can be seen from the stories about Russia in the international press over the past six months, which have definitely taken on a more positive tone. An example would be the way Russia behaved and was perceived to have behaved during the tragedy of the late Polish president's plane crash.

The difference between the perceived risk of Russia that exists in foreign investors' minds and the real risk of Russia is well illustrated by some particular stocks, such as those in the oil sector. The markets value Russian oil companies' oil in the ground at $2.50 per barrel, while Brazilian state-owned Petrobras is currently carrying out a capital increase that values its oil in the ground at $8 per barrel. This discount is patently absurd when one considers that much of Petrobras' oil is in hard-to-get-at deepwater areas, while much of Russia's oil reserves being developed are found onshore. "Lukoil, a well-run private Russian oil firm, is trading at a PE ratio of 5x, a third of that of Petrobras, and there's no good reason for that," said Jacob Grapengiesser, an East Capital portfolio manager.

Bottom up

East Capital's bottom-up investment approach also tells a slightly less uncertain story to what the economists are telling. With fears persisting about the possibility of a double-dip recession in the region, the view from the ground is much better. "It's always interesting to look at what companies are saying and companies are doing pretty well," said Elam Hakansson.

Looking at some of the companies that presented at the East Capital Summit, Eduard Zehetner, CEO of Austrian property investor Immofinanz, called the property market in Russia "drastically undervalued", where yields at shopping centres stand at 12.5% compared with Poland where they are 6.5%. "You cannot argue 600 basis points between Moscow and Katowice is right, the valuation gap will close," he said.

Petr Dvorak, senior vice president of broadcasting at Central European Media Enterprises (CME), said there is still a huge level of growth in the advertising market in the six emerging European countries in which it operates, where there are far better prospects than those markets further west. Using figures to illustrate his point, he said total ad spend per capita in Western Europe is $248 but only $44 in CME's markets. "If you're a car maker or a manufacturer of consumer goods, it's much cheaper to do an ad here than in Germany and the growth potential is pretty high."

Top down

Looking at the macro picture, Bengt Dennis, a former governor of the Swedish central bank who sits on East Capital's advisory committee, said that most CEE markets have still not returned to full capacity; in many cases the markets are nearing growth rates of the past, but some are lagging and will take more time to get back there. He also said that while these economies look robust in the sense the statistics are strong, "domestic demand is still very, very weak and a real broad-based recovery will have to wait for a few reasons."

Those reasons include the need for continued tight fiscal policies to reduce debt and bring budget deficits down; unemployment is still high and job growth is slow; household balance sheets are weak; and demand for credit is still slow. "It will take time to correct the imbalances," he said.

For the investor, though, the important point is not to wait for that broad-based recovery to arrive and an economy running at full capacity before investing, because he or she will run the risk of missing out on the superior returns. "The stock market tends to be six to 12 months ahead of the real economy," said Marcus Svedberg, East Capital's chief economist.

Within the region, Dennis pointed out that those countries that went into the downturn with a good track record of running their economies have tended to recover much quicker, Poland being a prime example, which with some good luck but also good policies managed to avoid going into recession. At the other extreme are the Baltic countries, whose economies had grown too fast with too many imbalances and so the recovery has been more drawn out.

Even so, the Baltics should take some credit for addressing the problems head on, especially Estonia, which adjusted quickly and is now due to join the euro from next year. "Latvia won't be back to 2007 GDP growth levels until 2015 or so, there will be many lost years for Latvia," said Dennis.

Looking at Central Europe, some of the latest data is at levels that could be called "booming" - for example, industrial production growth numbers are strong partly because Germany is growing well, but also because of the low base, since output dropped so sharply during the crisis. "Domestic demand is still weak, though exports are growing quite briskly," said Svedberg.

By contrast, Turkey is one of the least export-dependent economies in the region but is benefiting from strong domestic demand from its young and growing population, which is driving the economy and the stock market is reaching all-time highs this year. "I can't help but be impressed by how Turkey has acted during the crisis," said Svedberg.

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